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INSIGHT: Mitigate cost and risk with bunker fuel hedging approaching IMO 2020

15 Aug 2018

In the second of two articles on the 2020 sulphur cap changes, Chris Hudson of Freight Investor Services (FIS) takes a look at the response of the refining industry and how the derivatives market is also adapting.

I’m sitting here writing this wearing a ‘Keep Calm and Keep on Shipping’ T shirt, and that’s definitely the attitude to take. After outlining the legislation and some solutions in the previous two articles, and now looking at the options open to the refining industry, we are sure that things are not going to be as cataclysmic as some people have predicted.

This said, the refining industry has a big responsibility in ensuring that there is a smooth transition to the new 0.5% sulphur grade fuel oil, something in which it got no say at IMO. This will be no small feat to achieve, requiring a huge change, not only to the refining process, but the whole chain from crude acquisition to product distribution.

It will be a difficult balancing act to achieve a smooth transition into 2020. It is estimated that global maritime consumption of high sulphur fuel oil will be at 240 million tonnes, before then dropping dramatically to 45 million tonnes come 2020. To be able achieve this level of demand before switching product will require careful management and planning, not only in production, but distribution and storage. I do not envy those whose task it is to achieve it.

There are several ways that the refining industry can prepare to meet the demand for lower sulphur content: they can use lower sulphur ‘sweeter’ crudes, upgrade refinery capabilities (such as ENI’s EST hydrocracking process), or by blending.

The first option will be sweet music to the ears of U.S. crude producers which could see their product even more in demand from refiners. This, of course, will be true of other sweeter crude producers like Brent and Saharan Blend and will push up the premium for this crude as fuel oil demand grows. It’s no surprise then to read that the discount for sour crudes compared to Brent is likely to move from about $6 discount to $10 or more in 2020, before reducing again as refineries increase their ability to process sourer crudes into the new decade.

The limitations of world crude supply mean this is by no means a long-term fix, but it may explain how the sudden demand for lower sulphur product can be satisfied. This could mean a higher premium on fuels from areas using this method to produce lower sulphur fuel, with refiners passing on higher costs to end users and perhaps this is the cost the shipping industry will have to pay to get past this unprecedented environmentally-driven shift.

Thinking industry-wide, the upgrading of refining capabilities is the more preferable but longer-term option. This option, however, will require the most planning and highest capital outlay. Upgrading the world’s refineries will take time and money, but time is something that we are very short of, as any upgrades will have needed approval months ago to be complete in time for 2020.

A good analysis of world refining capability and where the new fuel oil is going to be needed can be made by comparing expected demand growth and refining complexity in the different regions. Currently Asia, Europe, and North America make up some 44%, 22%, 13% respectively of world fuel oil demand. They are also the three areas that have above average refining complexity (in other words able to best respond to changes in demand – all are above seven on the Avg Nelson Complexity Index). This puts the industry in a good position to be able to deal with the changes in areas of the highest demand.

One example of refinery upgrading is the St Croix refinery, which has just received $1.4 million in investment to restart specifically to meet the demand for 0.5% fuel. This refinery will have the ability to convert lower cost heavier crudes to the required sulphur level or lower, and process some 200,00 barrels per day.

The last option for those who do not have the ability to use sweeter crude or to upgrade refineries is to blend their usual high sulphur fuel oil output with other products to ensure that it meets the requirements of the new regulations.

There have been reported several different grades of 0.5% fuel under development by some oil majors. BP has announced that it is developing an aromatic 163cst and a paraffinic 218cst grade; ExxonMobil is developing several grades for NW Europe, Mediterranean, Singapore and an expected U.S. Gulf grade; CEPSA has opted for a single 200cst 0.5% blend; other majors have not released any specifics on the grades they are developing.

This approach does seem the most labour intensive and hardest in terms of achieving stability and consistency of products due to the different blends produced from multiple grades of fuel. It is expected that this approach will push up premiums for distillates as demand increases for blending.
In general, it’s clear that the refining industry has its work cut out to get the required fuel ready for January 2020. Be it using sweet crude, refinery upgrades or blends there are plenty of options to ensure a roll-out of compliant fuel to replace HSFO.

What happens in terms of the other difficulties of distribution and storage are more unknown, and there will, of course, be some hiccups on the road to an orderly introduction of the regulations. Buyers need to be aware of the options and there should be contingency planning in case 0.5% fuel oil isn’t available where and when it is needed.

The changes in the physical grades and flow will, of course, cause a necessary change in all the associated industries from port infrastructure to insurance. At FIS our speciality is fuel oil hedging solutions for end user clients, so we will take a look at the developing paper market with respect to the low sulphur fuel switchover and what options these end users have.

I think it is fair to say that there is currently no perfect hedge for potential 2020 fuel risk, with the exception of continuing to use HSFO on scrubber-fitted vessels (or in the case of non-compliance).
For operators planning on using HSFO, the tried and trusted HSFO derivatives contract will give the perfect solution for being able to guarantee the costs of the fuel well into 2020.  Currently everyone dislikes you, but at least you’re sorted. 

For the majority of people their solution for the new IMO regulations will be using a blended 0.5% fuel oil, for which currently there are no direct equivalent paper contracts. To do so presents a choice for those who are looking to mitigate their fuel price risk in upcoming years. But, like squeezing into that pair of jeans from your 20s, those looking to hedge immediately will need to consider some slightly ill-fitting proxy trades.

For a proxy hedge most counterparties have looked at a lower sulphur content fuel such as the gasoil contracts in Rotterdam and Singapore respectively. The two most used contracts are the Rotterdam 0.1% Gasoil and the Singapore Gasoil 10ppm contracts, making them overly compliant, but they are liquid, correlated, and tradeable today. You’ll have to pay a pretty penny in premiums over both HSFO and the expected cost of 0.5% LSFO, but at least you will be able to sleep soundly at night knowing your hedge is on and working.

If you are able to sit on your hands for a few more months (which I suspect will be the position of the majority), then there will be specific 0.5% contracts coming into existence at the start of next year. Platts proposes to begin publishing new price assessments for RMG 380 CST marine fuel cargoes with a maximum sulphur limit of 0.5%, for loading in Singapore, Fujairah and Houston, and barges in Rotterdam, starting January 2, 2019.

And like the world’s best pick ’n’ mix for traders there will also be the corresponding spreads between the current high sulphur and these new low sulphur contracts. The FIS contact details are the bottom of this article, so do get in touch to get set up to hit the ground hedging once these new contracts are operational.

With this in mind, there a several ways to approach hedging exposure; proxy gasoil trades; wait and directly hedge the 0.5% contract, hedge the HSFO contract now and then use the spread to roll it into ULSFO contract when it is introduced.

Each solution is specific to each client and the level of risk or premium they are happy to accept, but at least there are some options available, and operators do not just have to accept whatever costs the 2020 changes throw at them.

As a specialist broker of fuel oil derivatives – as well as wet and dry forward freight agreements – at FIS we have the expertise to help devise and execute whatever hedging strategy works best to keep you ahead of the pack for the 2020 switchover.

Chris Hudson is a Fuel Oil & Tanker FFA Broker at Freight Investor Services (FIS).

Founded in 2002, Freight Investor Services is a specialist in dry bulk and commodity derivatives, including freight, iron ore, fertilizer and bunker fuel. The company has offices in London, Dubai, Singapore and Shanghai.

For further details about fuel oil swaps or to discuss trading opportunities, please contact the fuel oil desk on +44 207 090 1134 or chrish@freightinvestor.com.

Related: INSIGHT 2020: Refining the Issue

Published: 15 August, 2018
 

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